In a notable victory for the US Securities and Exchange Commission (SEC) in its closely-watched enforcement action against Coinbase over its crypto-assets activities, a New York federal court on March 27, 2024, rejected nearly all of Coinbase’s challenges to the SEC’s charges against it and cleared the case to proceed. SEC v. Coinbase, Inc., No. 1:23-cv-04738-KPF (S.D.N.Y. Mar. 27, 2024) (Katherine Polk Failla, J.). The court held that the SEC’s allegations about Coinbase’s crypto transactions were sufficient for them to “suffice to constitute ‘investment contracts’ under the three-pronged Howey test” and thus be subject to the federal securities laws and the SEC’s enforcement authority. The SEC’s victory was not total, however, as one specific claim as to Coinbase’s Wallet product was rejected, although on different grounds.
Background: The Howey test
The SEC had charged Coinbase with acting as a national securities exchange, a broker and a clearing agency with respect to transactions in thirteen identified crypto-assets, which the SEC contended were “securities” as understood under federal securities law, in violation of Sections 5, 6,15(a) and 17A(b) of the Securities Exchange Act of 1934, and of offering and selling securities without a registration statement in violation of Sections 5(a) and 5(c) of the Securities Act of 1933.
Coinbase made a preliminary motion to dismiss the SEC’s claims based simply on the pleadings. In this context, the court explained that it must “draw all reasonable inferences in [the SEC’s] favor, assume all well-pleaded factual allegations to be true, and determine whether they plausibly give rise to an entitlement to relief” in determining whether the claims should be allowed to proceed.
For all the SEC's claims, the court focused primarily on the frequently-litigated question from recent years of whether crypto-asset transactions amount to “investment contracts,” so as to fall within the statutory definition of a “security” under the framework developed by the US Supreme Court in SEC v. WJ Howey Co., 328 U.S. 293 (1946), and its progeny. That test requires “(i) an investment of money (ii) in a common enterprise (iii) with profits to be derived solely from the efforts of others.” The court was unequivocal in holding that the Howey test was met in Coinbase’s case, stating that “the well-pleaded allegations of the Complaint plausibly support the SEC’s claim that Coinbase operated as an unregistered intermediary of securities” because “the challenged transactions fall comfortably within the framework that courts have used to identify securities for nearly eighty years.”
Applying the Howey test to Coinbase
On “the specific question of whether the SEC has adequately pleaded that Coinbase intermediated transactions involving crypto-assets that suffice to constitute ‘investment contracts’ under the three-pronged Howey test,” the court noted that “[b]ecause Defendants do not dispute that purchasers of the Crypto-Assets make an ‘investment of money,’” its analysis would focus on the two remaining Howey prongs. As to these, the Court concluded that “the SEC has adequately alleged that purchasers of certain crypto-assets on the Coinbase Platform and through [Coinbase’s] Prime [service] invested in a common enterprise and were led to expect profits solely from the efforts of others, thereby satisfying the Howey test for an investment contract.”
Horizontal commonality
The court first held that “the SEC has plausibly alleged horizontal commonality.” It noted that the Complaint detailed how “token issuers, developers and promoters frequently represented that proceeds from crypto-asset sales would be pooled to further develop the tokens’ ecosystems and promised that these improvements would benefit all token holders by increasing the value of the tokens themselves.”
As a result, said the court, the ability of a token purchaser to profit “is dependent on both the successful launch of the token and the post-launch development and expansion of the token’s ecosystem. If the development of the token’s ecosystem were to stagnate, all purchasers of the token would be equally affected and lose their opportunity to profit. As such, the SEC has adequately pleaded that investors and issuers were joined in a common, profit-seeking enterprise.”
Rejecting an argument made by Coinbase, the court specifically held in this regard that “neither Howey nor its progeny have held that profits to be expected in a common enterprise are limited just to shares in income, profits or assets of a business.” Rather, it explained, what matters were “the profits that investors seek on their investment, not the profits of the scheme in which they invest,” and thus those profits may include “dividends, other periodic payments or the increased value of the investment.” Accordingly, it held that “the SEC has sufficiently alleged that investors reaped their profits in the form of the increased market value of their tokens.”
Efforts of others
Turning next to “[t]he final Howey prong” of “whether investors were led to believe they could earn a return on their investment solely by the efforts of others,” the court held that “[h]ere again, the SEC has adequately pleaded this requirement.” It noted:
- “The SEC has plausibly alleged that issuers and promoters of the Crypto-Assets—through websites, social media posts, investor materials, town halls and other fora—repeatedly encouraged investors to purchase tokens by advertising the ways in which their technical and entrepreneurial efforts would be used to improve the value of the asset, and continued to do so long after the tokens were made available for trading on the secondary market.”
- “Coinbase concedes that these statements reached not only the purchasers in the primary market at the initial coin offering stage, but also those potential investors considering whether to acquire the Crypto-Assets in the secondary market. Accordingly, an objective investor in both the primary and secondary markets would perceive these statements as promising the possibility of profits solely derived from the efforts of others.”
The court noted additional supporting allegations as well:
- “The SEC’s claim is further supported by allegations of communications, marketing campaigns and other public statements to the effect that token issuers would employ deflationary strategies to reduce the total supply of tokens and thereby affect the token price.”
- “Crypto-Asset issuers publicized to investors in the primary and secondary markets that profits from the continued sale of tokens would be fed back into further development of the token’s ecosystem, which would, in turn, increase the value of the token.”
The court thus concluded that “these specific factual allegations, taken as true at this stage, support the SEC’s claim that investors in a common enterprise were motivated to purchase certain crypto-assets based on an expectation of profits solely derived from the efforts of others. Accordingly, the Court finds that the SEC has adequately pleaded that Coinbase customers engaged in transactions involving the Crypto-Assets that amounted to ‘investment contracts’ under Howey.”
Rejecting Coinbase’s arguments about Howey
The court also addressed and rejected several other arguments that Coinbase had advanced with regard to the Howey test:
First, it said, “whether a particular transaction in a crypto-asset amounts to an investment contract does not necessarily turn on whether an investor bought tokens directly from an issuer or, instead, in a secondary market transaction. For one, Howey does not recognize such a distinction as a necessary element in its test of whether a transaction constitutes an investment contract, nor have courts, in the nearly 80 years of applying Howey, read such an element into the test. Rather, under Howey, the Court must consider the ‘economic reality’ of the transaction to determine whether that transaction is an investment contract.”
It declared “there is little logic to the distinction Defendants attempt to draw between the reasonable expectations of investors who buy directly from an issuer and those who buy on the secondary market. An investor selecting an investment opportunity in either setting is attracted by the promises and offers made by issuers to the investing public. Accordingly, the manner of sale ‘has no impact on whether a reasonable individual would objectively view the [issuers’] actions and statements as evincing a promise of profits based on their efforts.’”
Next, the court rejected Coinbase’s contention that “because the transfer of a crypto-asset from one investor to another on its platform does not involve the transfer of any contractual undertaking, no sale of an investment contract can take place.” It held that “[s]uch a requirement . . . is not formal, but formalistic, and cannot be fairly read into the Howey test.” It noted that “since Howey, no court has adopted a contractual undertaking requirement,” and “courts in this Circuit have repeatedly rejected efforts by defendants in the cryptocurrency industry to insert such a requirement into their Howey analysis.”
Lastly, the court rejected Coinbase’s floodgates argument that construing Howey so broadly could unleash a regulatory power-grab by the SEC “over essentially all investment activity,” including over virtually any commodity that could be bought or sold. “Not so,” said the court. “Contrary to Defendants’ characterization, a Coinbase customer does more than simply part with capital in the hopes that her purchase will increase in value. Such a characterization ignores Howey’s second element, the need for a common enterprise. When a customer purchases a token on Coinbase’s platform, she is not just purchasing a token, which in and of itself is valueless; rather, she is buying into the token’s digital ecosystem, the growth of which is necessarily tied to value of the token.”
Thus, the court continued, “[i]n this way, the offer and sale of cryptocurrencies can be distinguished from commodities or collectibles. Unlike in the transaction of commodities or collectibles (including the Beanie Babies discussed during the oral argument), which may be independently consumed or used, a crypto-asset is necessarily intermingled with its digital network—a network without which no token can exist.”
Non-Howey objections rejected as well
The court also dismissed other objections not grounded in the Howey test that Coinbase made to the SEC’s exercise of enforcement authority.
“Major questions” doctrine held inapplicable
The court found that the SEC’s enforcement action “does not implicate the major questions doctrine.” It noted that “while certainly sizable and important, the cryptocurrency industry falls far short of being a portion of the American economy bearing vast economic and political significance,” in contrast to “those other industries the Supreme Court has found to trigger the major questions doctrine.”
“[M]ore importantly,” it said, “the SEC is asserting neither a transformative expansion in its regulatory authority, nor a highly consequential power beyond what Congress could reasonably be understood to have granted it.” Rather, it found the SEC was “exercising its Congressionally bestowed enforcement authority to regulate virtually any instrument that might be sold as an investment.”
The court further noted that “[t]he very concept of enforcement actions evidences the Commission’s ability to develop the law by accretion.” In the court’s view, “[u]sing enforcement actions to address crypto-assets is simply the latest chapter in a long history of giving meaning to the securities laws through iterative application to new situations.”
Complaints of lack of “fair notice” rejected
The court also rejected Coinbase’s objections the SEC’s had failed to provide “fair notice” that it would employ its powers in this way toward crypto, supposedly contrary to due process and the requirements of the Administrative Procedure Act. It held that “the broader timeline of the SEC’s positions regarding crypto-assets”—going back to the SEC’s 2017 “DAO Report” and its numerous enforcement actions since then—“reveals that the SEC provided Coinbase (and similarly situated actors) fair notice—through written guidance, litigation, and other actions—that the sale or offering of certain crypto-assets could prompt an enforcement action by the SEC.” It also noted that Coinbase itself had conducted risk assessments and engaged in other activities showing an appreciation of the potential issue it might face.
It thus concluded that “[h]ere, the SEC is not announcing a new regulatory policy, but rather is simply engaging in a fact-intensive application of an existing standard—an application that Coinbase also conducted—to determine whether certain transactions involving crypto-assets meet the characteristics of an ‘investment contract.’”
Conclusion
Many in the industry had expressed hope that Coinbase might finally deal a blow to the SEC’s enforcement actions against leading crypto industry players and curtail its regulatory ambitions. Despite what some observers felt might have been promising signals during oral argument of Coinbase’s motion, the court sided strongly with the SEC, pushing back only on one small point about whether Coinbase’s activities as to one of its products met the definition of acting as a “broker” even if “securities” were involved.
SEC v. Coinbase thus presents yet another decision in support of the SEC’s exercise of authority over the crypto space. While this preliminary decision merely addresses the sufficiency of the SEC’s allegations at the pleading stage, and does not guarantee that the SEC will be able to muster sufficient competent evidence following discovery to withstand summary judgment or to prevail at trial, the ruling rejects many of the legal arguments the industry had hoped would shut down or curtail the SEC’s efforts.
However, the decision should not be read to stand for more than it actually says. The SEC did not assert sweeping allegations about all crypto-assets, but only about the thirteen particular ones it had identified. The court itself noted the possibility that the outcome might be different in cases where the key allegations about those crypto-assets that were cited in this decision are not present. Thus, despite the court’s firmly-worded conclusions as to the SEC’s claims in this case against Coinbase, the results in future cases will necessarily continue to remain dependent on their individual facts.
